Friday, April 18, 2008

I didn't see the recent debate between Barack Obama and Hillary Clinton, but I came across the transcript here. At one point, the debate turns to the economy, specifically the capital gains tax. Obama favors raising the capital gains tax. However, as the moderator points out, each time the rate has been lowered (first by Bill Clinton, then by George W. Bush) the revenues the government have collected from the tax have gone up. Given this, why does Obama want to raise it at all?

Obama's response is interesting:

OBAMA: Well, Charlie, what I've said is that I would look at raising the capital gains tax for purposes of fairness.

We saw an article today which showed that the top 50 hedge fund managers made $29 billion last year -- $29 billion for 50 individuals. And part of what has happened is that those who are able to work the stock market and amass huge fortunes on capital gains are paying a lower tax rate than their secretaries. That's not fair.

And what I want is not oppressive taxation. I want businesses to thrive, and I want people to be rewarded for their success. But what I also want to make sure is that our tax system is fair and that we are able to finance health care for Americans who currently don't have it and that we're able to invest in our infrastructure and invest in our schools.

And you can't do that for free.

Some bloggers have taken Obama's statement to mean that he thinks "fairness" is always more important than growing the economy or increasing government revenue. This is an absurd interpretation of Obama's remarks.

Let's look at it this way: let's assume that cutting the capital gains tax down to 12 percent would make at least one person better off and nobody worse off. To use some jargon, cutting the tax down to 12 percent would be a Pareto improvement, relative to the status quo.

To some, if we can show that a policy is a Pareto improvement, that is all that needs to be said on behalf on that policy. Ideally, all policies should lead to Pareto improvements. Indeed, the aim is to reach Pareto efficiency, a state in which no further Pareto improvements can be made -- in which nobody can be made better off without making someone else worse off.

I do not think that is all there is to say. Consider a policy, P, that is a Pareto improvement. It makes at least one person better off and nobody worse off. However, this policy, P, was written on behalf of a certain lobbyist group. The one person that P will make better off is the lobbyist himself. It won't make anyone else worse off, at least compared to the status quo, but it won't exactly benefit them, either. We might say: the large benefit the lobbyist will receive from P will translate into smaller benefits for everyone else. Or maybe P simply allocates some "windfall" to the lobbyist that was not previously allocated to anyone.

The point is that P, while a Pareto improvement, is also unfair to the rest of us. Consider an alternative to P, policy Q. Q is also a Pareto improvement over the status quo. But the people who will benefit from Q are those who, prior to Q, were the worst off in society, according to some measure (and I admit, figuring out who the worst off are is difficult if not impossible.) I would argue that on fairness grounds, Q is better than P.

Obama, I think, is familiar with John Rawls' work A Theory of Justice. Consider three policies, each representing a Pareto improvement over the status quo:

Policy P: only benefits the wealthy person who lobbied for the policy in the first place.Policy U: maximizes the welfare of society taken as a whole.Policy Q: maximizes the welfare of the least advantaged, the worst off in the society.

The jury is still out on whether Rawls adequately makes the case for Q, the policy his own theory would likely favor, over U, the policy a utilitarian would favor. But consider this: neither P, nor U, nor Q can be policies that would (say) bring the economy to a screeching halt or reduce government revenues to zero or anything like that. This is because we've only "allowed in the door" policies that are a Pareto improvement over the status quo, and any policy that would destroy the economy cannot represent a Pareto improvement.

Thus, Obama and Rawls both reject "oppressive taxation", because such policies are, in the end, of no benefit to anyone. But among the policies that are Pareto improvements over the status quo, a choice must be made. Cutting the capital gains tax may make at least one person better off and nobody worse off; but so might leaving the tax where it is. The difference would be who will benefit from the policy. Obama seems to think that question matters, and so do I.

But there need not be an absolute trade off between economic efficiency and fairness: rather, the idea is to fairly allocate the benefits that come from having an efficient economy, without compromising the efficiency of the economy in the process.

I tend to think shrinking the government drastically would actually represent a huge move toward Pareto efficiency. Everyone, including lobbyists, would be better off if government had less power over the economy. In fact, there is a case to be made that it is precisely the worst off in society who would benefit the most from reducing the power of government. While Rawls would never have interpreted himself in this way, we can, in conjunction with the insights of public choice economics, make a pretty good case for libertarian economic reforms on Rawlsian grounds.